Dollar cost averaging (DCA) is a strategy used for accumulating assets, usually shares of common stock and mutual funds (both stock and bond funds). The strategy calls for the investment of a fixed dollar amount on a periodic basis. An example of this would be investing $100.00 per month in a mutual fund. This is a strategy that is built into 401K and other retirement plans funded through automatic periodic deductions from pay. Some benefits of such a strategy are as follows:
1. Convenience—it is easy to plan for investment. Many banks and mutual fund companies allow an automatic disbursement from a checking account to the fund. Retirement plans make automatic deductions from pay.
2. Introduction to investing—dollars for a lump sum investment may not be available. For someone who is just starting to invest, this may be all that can be afforded.
3. Averaging share cost—by investing a fixed sum periodically, the number of shares acquired at any given time will be based on the share price. If the share price has risen, fewer shares will be purchased. If the share price has decreased, more shares will be purchased. Over time, it is the purchases made when prices are lower that reduces the average cost of the shares. If the share price was to subsequently rise, greater capital gains would be obtained. This strategy may make more sense using mutual funds than individual stock because if an individual company fails, the share price may never recover. In contrast, if a company held by a mutual fund fails, the fund share price would be less impacted.4. Time value of money—a dollar received today is worth more than a dollar received next year because today's dollar can be invested and earn interest so that a year from now, its value will be 1+(i/100%), where i=the annual percent interest rate earned. Consider two separate investments of $1000, each equaling $2000 in seven years. If investment A required payment of the $1000 at the beginning but investment B allowed periodic monthly payment over the seven years, investment B would be preferred because the amount of the $1000 not yet invested could be earning interest.
It may be perceived that this periodic investment should go on forever with the investor adding to the amount of investment over time as income increases. The latter actually happens automatically in retirements plans that are based on a percentage of pay, every time pay is increased. Many financial websites extol the virtues of dollar cost averaging and even provide tools that may be used to simulate returns based on the amount invested and various share prices. The same is true for retirement plans.